Financial Accounting Fundamentals

 

Introduction 

The culmination of the accounting process is the production of the financial statements. 

Financial accounting is the organization and summarization of the financial data records into reports to be given to people outside the company who might be thinking of loaning the company or investing in the company.

And then the real fun begins, the analysis of those financial statements. Users of those financial statements examine the statements to see trends over time.

Accounting Basics: Accounting vs Book Keeping 

• The most fundamental type of accounting is bookkeeping. Just the routine, systematic gathering of data, making sure that everything gets recorded. 

• Financial accounting is the organization and summarization of these bookkeeping data into reports to be given to people outside your company who might be thinking of loaning you money or who might be thinking of investing in your company. 

• Bookkeeping is the system in place to capture the raw data. Financial accounting is the organization of these raw data into Summary Reports or Financial Reports or Financial Statements. 

These financial reports can be thought of as 3 pieces of paper:  The Balance Sheet, the Income Statement, and the Statement of Cash flows.

Point To Note

• The Balance Sheet, the Income Statement, and the Statement of Cash Flows are Summary Reports that are provided by businesses to people outside the company. 

• So those people outside can decide, "Should we loan that company money?" "Should we invest in that company?"

• Bookkeeping involves the capture and recording of the raw data. 

• Financial accounting involves organizing those data into three fundamental financial statements.

The Accounting Equation 

• The balance sheet is built around one of the most awesome creations of the human mind, the Accounting Equation which states that -. 

Assets = Liabilities + Equities

         Note: Borrowed = Liability, Invested By Owners = Equity

• The first side, the Asset Side is the real world. You can go touch a company's assets. It's cash, it's buildings, it's land. That's the real part of a company. 

• The other half of the accounting equation just tells you where you got the money to buy those assets. I.e. the source of the financing to buy that asset - Did I borrow the money to buy the asset? Was the money invested by the owners? 

• If I borrow the money, then liability is the name I give to the source of the financing to buy that asset. 

• If the money was invested by owners or shareholders, I say, equity was the source of the money to buy the asset. 

These financial reports can be thought of as 3 pieces of paper:  The Balance Sheet, the Income Statement, and the Statement of Cash flows.

The Financial Statement : Balance Sheet

• The first primary financial statement is the balance sheet. 

• A balance sheet is a listing of a company's valuable resources, its assets. 

• An asset is defined as a tangible thing, or an intangible right that a company owns or controls and that's expected to generate benefits in the future. 

• For example, land a company owns is an asset because in the future that land can be sold, generating a benefit in the form of cash received or the land can be used in the business, providing a benefit in the form of the location of business operations. 

• A balance sheet also shows the three general sources that companies use to get money to buy assets :-

• Source1 - Borrowing : Now if you borrow money, of course you have to pay it back. This obligation to repay an amount borrowed is called a liability. 
• Source2 - Owner/Shareholder Investment : Owners or Shareholders can take money from their private savings and invest it in the business. 
• Source3 - Company Profits : The company can generate profits, which belong to the owners that are then kept in the business to buy more assets. 

• Together, these two sources of financing, owner-direct investment and retained profits are called equity. Equity is the amount of total financing provided by the owners. 

• The fundamental difference between liabilities and equity is that liability amounts must be repaid to the lenders, whereas equity amounts do not have to be repaid. 

• If owners repay equity amounts, they are reclaiming some of their investment funds and voluntarily shrinking the size of their investment in their business. So,  Assets, liabilities and equity, those are the items found in the balance sheet. 

Point To Note

• Goodwill represents the extra amount a company paid for the reputation, customer relationships, and employee relationships of companies it has purchased over the years.

Liabilities:

1. Short-term Borrowings: Amount of money the Company borrowed that it's going to have to pay back within one year.

2. Accounts Payable: This represents the amount the Company owes to its suppliers for inventory that they have already received, but have not yet paid for.

3. Long-term Debt: This is the amount of money the Company borrowed in order to buy assets using loans that Company can wait more than one year to repay.

• Retained earnings is the cumulative amount of profits that have been generated by the Company that have been kept in the business and used to buy assets.

The Financial Statement : Income Statement

• The second primary financial statement is the Income Statement. 

• An Income Statement is a report telling how much money a company made during the month or the quarter or the year, whatever period is covered by the income statement. 

• Now the Income Statement contains Revenues and Expenses

• The Revenue amount is the amount of assets generated through business operations. In 2018, Company (C) generated over $500 billion in assets by selling stuff to you and to me. 

• Now the Expense amount is the amount of assets consumed in doing business operations. 

• During 2018, Company (C) consumed $385 billion in paying suppliers for the inventory items sold to you and me. Now the difference between revenues and expenses is called Net Income [Revenues-Expenses = Net Income]. Hopefully this difference is positive, meaning that the company's business operations have generated more assets than they've consumed. 

• Net Income is the measure of economic performance of a Company (C). [Net Income = Revenue - Expenses]

• Think of Sales as the retail selling price and Cost of Sales is the wholesale purchase cost that Company (C) had to pay to buy the items. 

• What else does a company have to pay for out of the $100 that they just got from us? Well, they have to pay the cashier. They have to pay the store manager. They have to pay for the electricity. They have to pay for property taxes. They have to pay for advertising. These expenses are reported under the heading, operating, selling, general, and administrative expenses. Now Company (C) is left with what's called their Operating Income. 

• Other miscellaneous gains and losses, income before income taxes

• If I pay Company (C) $100 for something, how much did that thing cost Company (C)? Well, we can find that out by dividing cost of sales by net sales. The answer's about 75%. In other words, if Company (C) sells you and me something for $100, Company (C) has to pay its suppliers $75 to buy that thing. 

The Financial Statement : Cash Flow Statement

• The third primary financial statement is the statement of cash flows or Cash Flow Statement, which is a report of a company's Cash Receipts and Cash Payments, separated into three categories: Operating, Investing, and Financing. 

• Operating Cash Flows are the things that companies do every day, collecting cash from customers, paying employees and so forth. 

• Investing Cash Flows are investments in the productive capacity of the business. Buying more buildings and trucks and land and so forth. 

• Financing activities involve getting the money to buy the stuff that I need through borrowing and through shareholder investment, and then repaying loans and paying dividends to shareholders. 

• The Statement of Cash Flows or Cash Flow Statement is the report of the amount of cash collected and cash paid. 

• The structure of the statement of cash flows is to separate the cash flows into three categories:

• Operating activities are the things that you do every single day, your operations. For example, Company (C) collects cash from its operating activities when it collects cash from selling items to you and me. Examples of cash outflows from operating activities are cash paid for wages, for utilities, for taxes, and for interest. 

• Investing activities Here, the word investing means investing in the productive capacity of the business. So cash outflows from investing activities are buying new buildings, buying new land, buying new machines. 

• Financing activities Financing activities are just what they sound like, borrowing money and getting new investment cash from owners. Common cash outflows from financing activities are the repayment of loans and the payment of dividends to owners. 

Note:- A cash cow is a company that generates so much cash from its day-to-day operating activities, that it can pay for all its new buildings, land, and trucks in cash and still have cash left over. 

TERMS RELATED TO ANALYSIS OF FINANCIAL HEALTH OF A COMPANY

1. Authorized Share Capital
To sell stock to the public, a business must first register with a governing body. Part of this registration includes documentation of the amount of capital the business is looking to generate through selling stock. This amount is called its authorized capital and is the maximum amount that can be raised in this manner.

2. Paid-up share capital & Called-up share capital 
Investors have already paid in full for Paid-up capital. Called-up capital has not yet been completely paid, though payment has been requested by the issuing entity.

3. Different Types of Equity Financing
Equity financing can take form through a variety of different investors. These investors can include venture capitalists, angel investors, institutional investors, private investors, and public offerings.

4. EBITA

It is a commonly used acronym by investors, standing for 'Earnings before Interest, Taxes and Amortization'. 

5. Operating Revenue

Revenue is the total amount of income generated by a company for the sale of its goods or services before any expenses are deducted. Operating Revenue (Operating Income) is the sum total of a company's profit after subtracting its regular, recurring costs and expenses.

Operating Revenue = Gross Profit (or Net Revenue or Net Income) – Operating Expenses – Depreciation – Amortization.

6. Networth

The shareholders' equity, or Net worth or Net Income or Earnings, of a company equals the total assets (what the company owns) minus the total liabilities (what the company owes). If your company does well, its profits increase and its net worth increases too. 

Net Worth or Net Income or Earnings or Equity (Invested by Owners) = Assets - Liabilities

7. Debt to Equity Ratio

Debt/Equity Ratio is a measure of a company's leverage and is computed as total liabilities divided by total assets. The debt ratio summarizes the degree to which a company has borrowed the money needed to buy its assets compared to getting that money as an investment from owners.

Debt Ratio = Total Liabilities (Borrowed Money)/Total Assets (Owner Investment or Equity)

 

Company (C) has borrowed 73% of all the money it needed to buy its assets. Now, a general rule of thumb for large companies around the world is that debt ratios are usually between 50 and 60%. So we see that Target has substantially more leverage than average. 

8. Return on Equity, or ROE

It is a measure of the amount of profit earned per dollar of owner investment. ROE is computed by dividing net income by equity.

ROE= Net income / Equity

9. Current Ratio

The current ratio is a popular metric used across the industry to assess a company's short-term liquidity with respect to its available assets and pending liabilities. In other words, it reflects a company's ability to generate enough cash to pay off all its debts once they become due. It's used globally as a way to measure the overall financial health of a company.

Standard range of acceptable Current Ratios

It varies depending on the specific industry type, a ratio between 1.5 and 3 is generally considered healthy. A ratio value lower than 1 may indicate liquidity problems for the company, though the company may still not face an extreme crisis if it's able to secure other forms of financing. A ratio over 3 may indicate that the company is not using its current assets efficiently or is not managing its working capital properly.

Current Ratio Formula

The current ratio is calculated using two standard figures that a company reports in it's quarterly and annual financial results which are available on a company's balance sheet: current assets and current liabilities. The formula to calculate the current ratio is as follows: Current Ratio=Current Assets/Current Liabilities

Current Assets Current Assets can be found on a company's balance sheet and represent the value of all assets it can reasonably expect to convert into cash within one year. The following are examples of current assets:

Cash and cash equivalents, Marketable securities, Accounts receivable, Prepaid expenses, Inventory

10. Trade Receivables or Accounts Receivable

Trade receivables are defined as the amount owed to a business by its customers following the sale of goods or services on credit. Also known as accounts receivable, trade receivables are classified as current assets on the balance sheet.

Concluding Remarks: The knowledge of Financial Accounting is necessary to prepare the Financial Statement or Reports of the company. We analyze financial statements to tell us if a company has done well or poorly in the past and help us see how the company might do in the future. With financial statement analysis, one can begin to spot trends in the financial statement data that provide clues as to what the future might hold. It is a very good document to understand how past decisions have affected the financial statements and how decisions made now might affect the statements of the future. 

Blog Author- Sameer